The coronavirus was actually a somewhat predictable event, in that the world was pretty much destined to eventually face another fast-spreading, novel illness. What wasn’t easy to foresee was the global economic shutdowns used to slow its spread. These shutdowns have exposed the very material differences between key sectors of the real estate investment trust (REIT) space. Here’s one of the biggest differences you should forever keep in the back of your mind.
One odd number
Hotel REITs have been exceptionally hard-hit during the global pandemic. To put a number on that, Park Hotels & Resorts (NYSE: PK) had pro forma occupancy at its 53 properties of roughly 80% in the final quarter of 2019. That dropped to 62% in the first quarter of 2020 as COVID-19 began to spread. And it fell to just 6% in the second quarter, which, so far, has represented the worst of the global hit — noting that COVID-19 cases are on the rise again. The third quarter of 2020, meanwhile, saw occupancy improve to 42%, much better but still well below pre-pandemic levels.
At the other end of the spectrum, diversified net lease REIT W.P. Carey‘s (NYSE: WPC) occupancy levels really didn’t change during the first nine months of 2020. In fact, this key metric increased from 98.8% to 98.9% between the first and third quarters.
Meanwhile, occupancy levels at apartment landlord AvalonBay Communities (NYSE: AVB) held up fairly well at the start of the pandemic but have slowly deteriorated as the crisis dragged on. Numbers will help. In the fourth quarter of 2019, occupancy at what the REIT calls established communities stood at 96%. At the end of the first quarter of 2020, that rose to 96.4% but fell to 94.8% at the end of the second quarter and 93.1% in the third. And it’s likely to keep falling for at least a little longer as well.
What’s going on?
What’s pretty clear from these three REITs is that Park’s business fell off a cliff. AvalonBay’s portfolio held up well at the start but is starting to show some weakness. And W.P. Carey’s occupancy has been virtually unaffected, as have its rental collection rates, which sit at roughly 99%. There’s one very important difference between these three REITs and, correspondingly, to the sectors in which they operate. It shows up very glaringly in the effective lease agreements they have with their tenants.
Hotels don’t really have leases per se. People only stay in them for a few nights at a time when away from home on business or a vacation. Moreover, there’s usually little to no economic impact if a customer cancels a hotel stay or leaves early. Effectively, the lease length is just a single night. Thus, when COVID-19 hit and people stopped all travel, Park’s business was immeditably hit. Although the impact was fairly dramatic, this isn’t actually a unique situation. Any economic downturn will have a similarly swift impact on a hotel REIT’s occupancy.
Apartments, meanwhile, tend to have one- to two-year leases. That provides a little leeway for really short-term events but not a whole lot of protection when the impact lingers a little bit longer. Yes, people need to have a place to call home, but COVID-19 and the recession the U.S. fell into in February are slowly starting to cause some pain for apartment owners as leases roll over. AvalonBay’s story is clear evidence of this.
The effect is that AvalonBay is starting to offer concessions to maintain its occupancy, since an empty apartment doesn’t produce any rental revenue. Some perspective: The REIT’s rental concessions through the first three quarters of 2019 were around $1.1 million. In 2020, that figure is $27.5 million. And once AvalonBay locks in lower rental rates, they’ll stick around for the entire lease. So a recovery will take a year or two to work through the portfolio, just like a downturn will take some time to show its impact.
W.P. Carey’s average lease length at the end of the third quarter was 10.6 years. Generally speaking, it also has annual rent escalators built into its contracts. So even when times are tough, it can raise the rates its customers pay. That offers it a huge amount of protection from economic and business downturns, including an unusual event like the global pandemic. It’s hardly immune, since a bankruptcy could quickly lead to empty buildings and missed rent payments. However, because its lessees have signed long-term deals, occupancy is usually not a big issue over short periods of time.
Know what you own
Most of the time, investors don’t pay much attention to lease length differences between different REIT sectors. But they’re important to understand because they can dramatically change how a business, and thus REIT stocks, will perform when times get tough. The swift occupancy decline at hotels is a warning that this specific niche may be riskier than you think.
The slow-moving drop apartment landlords are seeing, which will likely linger a bit after the market begins to improve, is equally important to keep in mind. While less risky than hotels, the one- to two-year lease length changes the dynamics of the business.
The same could be said of office REITs but with generally longer leases creating different lag times. Meanwhile, the very long lease lengths in the net lease space provide a huge amount of protection from short-term disruption. There are other sectors that sit in between, of course, but the key takeaway here is this: Lease length matters, and make sure you understand how it impacts the REITs you own.